An Overview of Stock Option Plans
Under a typical stock option plan, an employer provides their employee with a right to purchase a certain number of shares for a stated exercise price. Generally, the option vests over some time period, and if an employee leaves their employment with the company before the option vests, it is cancelled and returned to the option pool.
FOR EXAMPLE: ABC Inc. (“ABC”) is a Canadian-controlled private corporation (“CCPC”). In Year 0 its shares are worth $1/share. Bob and Amy are Canadian employees of ABC. ABC Inc. grants an option to Bob to purchase 100 shares at $0.10/share, and grants an option to Amy to purchase 250 shares at $1.00/share
When an employee exercises an option, an employment benefit is realized calculated as the difference between the fair market value (“FMV”) of the share on the date of exercise and the exercise price. If the company issuing the option is a CCPC, the employment benefit will not be added to the employee’s income until the year the share is sold. In all other cases, it is included in the employee’s income right away. For income tax purposes, if the exercise price of the option is equal to the FMV of the underlying stock at the date the option was issued, or in the case of a CCPC if the share is held for at least two years, only half of the employment benefit will be taxable (such that the employee has capital gains like treatment on the employment benefit). The employment benefit is otherwise taxed as regular employment income.
LOOKING AT BOB AND AMY FROM THE EXAMPLE ABOVE: In Year 5 when ABC’s shares are worth $3/share, both Bob and Amy exercise their options:
- Bob pays $10 to get 100 shares; his benefit is $290 ($300 – $10). It will be taxed as full income unless Bob holds his shares for 2 years. The benefit will be added to his income when he disposes the shares
- Amy pays $250 to get 250 shares; her benefit is $500 ($750-$250). Only half ($250) of her benefit is taxable. The benefit will be added to her income when she disposes the shares.
If the option is exercised and the employee holds the shares for a while, until there is an exit, then the employee realizes a capital gain or loss depending on whether the value of the shares has increased or decreased since the option was exercised. If the value has gone down, the employee will be faced with the benefit and a capital loss (which is generally not going to reduce the tax payable on the benefit).
CONTINUING WITH BOB AND AMY FROM THE EXAMPLES ABOVE: In Year 8, ABC is sold to a third party purchaser.
If ABC sells for $5/share:
- Bob has proceeds of $500, a capital gain of $200 ($500-$300) and an employment benefit of $145 ($290 x 50%) to report in Year 8.
- Amy has proceeds of $1,250, a capital gain of $500 ($1,250-$750) and an employment benefit of $250 to report in Year 8.
If ABC sells for $2/share
- Bob has proceeds of $200, a capital loss of $100 ($300-$200) and an employment benefit of $145 to report in Year 8.
- Amy has proceeds of $500, a capital loss of $250 ($750-$500) and an employment benefit of $250 to report in Year 8.
If you have questions about stock options, or would like to discuss implementing an employee stock option plan, please contact us and we will put you in touch with one of our corporate lawyers.